Macy's, Penney, and Martha Stewart: Who Has the Upper Hand?

In the past month, Macy's has gone to court with J.C. Penney and Martha Stewart Living Omnimedia to prevent J.C. Penney from opening Martha Stewart shops within its stores. Macy's claims that it has an exclusive license to sell a variety of home goods under the Martha Stewart name. The trial has now gone into recess until April, and Judge Jeffrey Oing has ordered the three companies into mediation in the hope of resolving the dispute.

It is obviously difficult to predict the outcome of litigation or mediation; clearly, each company believes that it has made good on its obligations. However, I believe Macy's is likely to get a favorable ruling if the case goes back to court. Moreover, Macy's is in far better financial position than J.C. Penney or MSLO -- it was the only one of the three to earn a profit last year. J.C. Penney and MSLO are in an unenviable position: Both are strapped for cash, yet the best-case scenario probably involves them buying out Macy's exclusivity. If they do not fold, they risk seeing the judge affirm the exclusive relationship between Macy's and MSLO; he could also order J.C. Penney and MSLO to pay for Macy's court costs and damages.

The backgroundIn December 2011, J.C. Penney and MSLO announced a new "strategic alliance." J.C. Penney invested $38.5 million in MSLO, and planned to open Martha Stewart-branded shops within its own stores that would sell home and lifestyle merchandise. The deal was viewed as a lifesaver by MSLO's management, as the decline of print media has led to years of poor performance in its publishing segment, and J.C. Penney was offering better financial terms than Macy's.

However, Macy's executives had other ideas. Since 2006, Macy's has carried Martha Stewart goods as the centerpiece of its home collection, and Macy's believes it has an exclusive contract that runs through 2018 (after it was renewed last year). In January 2012, Macy's sued MSLO to prevent the company from putting Martha Stewart goods in J.C. Penney stores.

Not surprisingly, Macy's believes that it would be damaging for Martha Stewart products to become available at a competitor, particularly because J.C. Penney is significantly down-market from Macy's in terms of pricing and quality. Macy's subsequently sued J.C. Penney for interfering with its contract with MSLO, and the two cases were combined for trial .

The caseLawyers for Macy's have made a very simple argument: Macy's and MSLO have an exclusive arrangement covering a variety of home categories, and J.C. Penney convinced MSLO to breach that contract in order to get better deal terms and an equity investment. By contrast, J.C. Penney and MSLO have put forth a variety of defenses, e.g.: 1) Macy's breached the MSLO contract by using the Martha Stewart name to draw customers to Macy's but then under-pricing the Martha Stewart goods with private-label merchandise; 2) MSLO is allowed to sell goods in its own stores, which would include the shops within J.C. Penney; and 3) Martha Stewart-designed goods in the exclusive categories would be sold under a separate "JCP Everyday" brand.

So far, based on details that have become public, the case does not seem to be going well for J.C. Penney and MSLO. J.C. Penney CEO Ron Johnson had difficulty explaining away emails in which he said that Martha Stewart would have to "break the agreement" with Macy's. Later on, Martha Stewart admitted during cross-examination that she understood the Macy's agreement to prevent her company from selling to down-market retailers. These pieces of testimony put the second defense (that putting Martha Stewart shops in J.C. Penney would be consistent with the Macy's agreement) on shaky ground. Furthermore, J.C. Penney agreed not to sell the "JCP Everyday" goods until the case is resolved, indicating that lawyers did not feel confident that they could persuade the judge to let J.C. Penney introduce that merchandise as originally planned.

The potential outcomeBy sending the dispute to mediation, Judge Oing sent a clear signal that he thinks money can solve this dispute. Obviously, having Macy's retain exclusivity is incompatible with J.C. Penney opening Martha Stewart shops, so the best way to satisfy all three parties would be for J.C. Penney and MSLO to pay Macy's to terminate the exclusive contract.

Of course, J.C. Penney and MSLO could refuse to settle, but Judge Oing has not seemed very sympathetic to their side. He has stated that his decision will not be influenced by financial matters (such as J.C. Penney's and MSLO's struggles), and told J.C. Penney lawyers that their company had taken a risk by trying to go around Macy's exclusivity agreement with MSLO. This is no guarantee of how he would ultimately rule, but at the very least, it should highlight the risks for MSLO and J.C. Penney of going back to court and waiting for a verdict.

Foolish conclusionThe current litigation is exacerbating the problems that J.C. Penney and MSLO already face. From a financial perspective, they are in no position to pay a substantial sum to Macy's. On the other hand, without offering such an enticement, it is unlikely that they will convince Macy's to drop the lawsuit. Macy's has plenty of money to fund litigation, and a reasonably strong case; it therefore has fewer incentives to compromise.

While J.C. Penney is already an incredibly risky stock because of its terrible operating results over the past year, the ongoing lawsuit adds another layer of risk for the company. The home category has one of the biggest drags on J.C. Penney's revenue, and the company needs to open its Martha Stewart shops to improve its results. However, with a weak balance sheet, J.C. Penney cannot afford to buy out Macy's exclusivity. J.C. Penney thus faces a catch-22, and the downside for shareholders could be substantial if it does not find a way out.

J.C. Penney has been a train wreck whose comeback always seems just around the next earnings corner, but investors are beginning to doubt that CEO Ron Johnson can weave the same magic that he did at Apple. If you're wondering whether J.C. Penney is a buy today, you're invited to claim a copy of The Motley Fool's must-read report on the company. Learn everything you need to know about JCP's turnaround-or lack thereof. Simply click here now for instant access.